Emerging Markets Crash

How Capital Flight From Emerging Markets Affects You

Just like Americans returning from winter vacations, American dollars are also flying back to the U.S. from warmer climes right now — which could be bad news for emerging markets.

Over the past few weeks, there has been a pronounced capital flight out of these emerging markets. Argentina recently had to capitulate defending the value of its currency, while other emerging markets had to raise their interest rates drastically, just to continue to make their currency and debt look attractive.

To really understand why this is happening, one need only look at the reasons why people started investing in emerging markets in the first place. The 2008 economic crisis caused a lot of people to flee conventional markets as interest rates and stock prices started falling to record lows. Those willing to concede a little risk by investing in emerging markets would be rewarded with higher interest rates and growth, and billions upon billions of U.S. dollars were converted away in 2008 and 2009 in favor of these emerging market currencies. Today, however, the U.S. has been showing strength, with all signs pointing to growth and an increase of interest rates in the U.S. over the medium term. The mass exodus is being reversed, and the flight home is beginning.

Turkey, India and South Africa have all raised their key interest rates in a move to protect their currencies from freefall. While Brazil, Chile and Indonesia have also seen their currencies being battered, they will no doubt have to follow suit with rate increases of their own. It is thought that as much as $6.5 billion has been removed from Emerging Market Equity funds (exchange-traded funds that have a basket of stocks from companies in various countries) over the last week. The largest funds, like MSCI’s Emerging Markets Fund (EEM) and Vanguard’s Emerging Markets ETF (VWO), have each lost around 7% to 10% of their value, respectively, in the last nine trading sessions. Banks with presences in emerging economies, like HSBC Bank or BBVA Banco Frances, have also lost 8% to 10% during the same time. A recent article from Reuters discusses the major six European banks being exposed to investments upward of $3 trillion.

This has rattled markets worldwide, with even the Dow Jones falling almost 1,000 points since January 21st. One of the sparks that set this decline in motion can be traced back to China on around this date. Data emerged that their manufacturing sector was slowing due to reduced domestic demand. Articles started coming out about China’s shadow banks and their sketchy behavior, adding fuel to the fire by suggesting that China’s banks are not as transparent as they should be and could even be hiding billions of unsafe or toxic assets. While China will still show positive growth for their first quarter, like so many times in history, we see a flight to the U.S. greenback. The combination of fear and instability in some of these more fragile emerging markets, coupled with the increasing strength of the U.S. economy, has created the perfect storm for these currencies and their downward slide.

Canada, Mexico and England have also seen their currencies lose ground against the U.S. dollar. Even G8 economies are feeling the pinch of this newfound strength in the U.S. dollar. The Canadian dollar has lost 10% of its value over the last three months. While this is in part due to the Canadian economy and its lackluster performance (they are even rumored to be thinking of lowering interest rates). Canada and Mexico have a vested interest in reducing the value of their currencies. This would make their exports look that much more attractive to their biggest trading partner, the U.S. Canada has been trying to get the Keystone Pipeline approved for years now, to get their landlocked oil out of Alberta and sold Stateside — imagine how much more attractive buying that oil is if it’s 10% cheaper.

Turkey raised its interest rate by four percentage points (to 12%), and now, like many of these more fragile economies, they suddenly have to pay that much more on their loans. And with their currency sliding downwards against the American dollar, oil and fuel (always priced in U.S. dollars) costs that much more. Without getting into how inflation takes root and spreads, the cost of imports becomes very expensive, driving the cost of household items way up. These types of cycles are very difficult to get out of, and the most unfortunate part is that they always have a debilitating social impact.

With all of these factors creating a perfect storm for some emerging economies, new information from the U.S. revealed on Tuesday may affect this trend. Data showed a slowdown in the American manufacturing sector, signaling that growth is not as robust as once thought. Ironically, negative U.S. numbers could help to ease the downward spiral for these emerging economies, for now. This would be, however, just a stop along a very bumpy road for many emerging economies, and we can only hope that the toll is not too great.